Bank Of America's Future Depends On This

For those contemplating a forward valuation for Bank of America (BAC), an important question must be resolved first. The stock's valuation is at deep discount based on the price-to-book value metric used to appraise banks. At its current level, it reflects the conundrum of investors and a crossroads for the company. Either Bank of America will put overhanging issues behind it, or it will be overcome by them. The bank must resolve its mortgage issues, truly present secured capital, and begin to grow again, including through its mortgage activities; or the enterprise itself may be threatened by mounting requests for reimbursement from mortgage-backed-securities investors claiming bank fault in mortgage originations. If you can conclude what will develop either way for BofA, there's money to be made. However, today the stock sits in a sort of limbo because of the fog of the situation.

This is the key reason why my opinion for BAC varies over the short, medium and long-term. In my EPS preview for Bank of America I wrote, "…I would continue to avoid BAC long-term, though it could get a short-term lift from its pending EPS report." Well, the short-term is already over, and I think it is clear investors are best served now without the burden of the shares in their portfolios. Or are they?

Bank of America beat analysts' expectations on the bottom line Wednesday, but the way the company did so could not support the shares. BofA earned $0.19 per share, beating Wall Street's estimate for $0.16, based on Factset data. The shares were up roughly 0.9% in the early pre-market that day like I expected they would be, but as the report came under scrutiny, BAC closed 4.9% under par.

The problem started at the top line, but was much more complex than that. Revenues of $22.4 billion came in short of what analysts were expecting, and revenues net of interest expense declined 1.3% in the quarter and fell 15.6% from the prior year period. The bank funded less residential home loans versus the prior year, with those down 3.6%. Whenever revenue declines, investors stray. BofA is seeking to diversify its loan base, but the shadow of Countrywide continues to darken the company's outlook.

Still, nonperforming loans and net charge-offs improved, allowing the company to reduce its provision for credit losses. That along with its cost savings from the consolidation of its operations and layoffs of thousands of employees allowed the company to beat bottom line expectations. Plus, the bank says it will save $8 billion annually by 2015. Still, investors weighing the viability of an operation want to see top line growth and a company without significant enterprise risk. While the bank shored up its capital, it faced a mounting problem that stirred investor and analyst anxiety, which was evident in the conference call.

An intensifying and concerning development called into question the sustainability of recent share price gains and began to chip at them. The demands of mortgage-bond investors and insurers weigh on BofA, as demands to buy back mortgages increased by an astounding $6 billion through the quarter, rising to $22.7 billion. The bank said some of it was due to inconsistencies in how Fannie Mae (OTCQB:FNMA) was reporting flaws in mortgage loans. The company fended off concerns by seeking to assure its attentive audience that the total costs of such actions wouldn't surpass a billion dollars, if I understood correctly. It said many of the claims had no legal footing but were pursuing recovery anyhow. That, to me, simply offers illustration of the litigious nature of our society. Or maybe we just have too many crooks.

This is a serious issue, as evident in the company's valuation penalty. Bank of America is priced cheaper than its big bank peers.

Clearly, other issues are weighing on all the banks as well, including the Libor scandal that cost the CEO of Barclays (BCS) his job and is expected to implicate several more banks. Plus, there was Moody's (MCO) downgrading of bank credit ratings recently. The rating agency listed BAC among a short list with Citigroup (C) and Morgan Stanley (MS) at most risk to capital markets activities while noting its exposure to Europe. We covered that issue in our article entitled Why Bank of America Shares are at High Risk. The article spurred a lively debate among shorts and longs in the stock and in the shares of Citigroup and Morgan Stanley.

Oftentimes, stocks are deeply depressed for good reason, and a cheap valuation does not necessarily mean the stock will appreciate in value. The term "value trap" does not elude BAC, and can only be disproven by resolution of its significant risks, especially the mortgage issue. The stock could thus make up valuation ground, or it could instead prove short interests correct. For those of us attempting to make a case either way for BAC, we must first determine whether these issues will be resolved in a less than catastrophic manner or not. I await your value-added opinion on the issue with great interest.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.